September 2, 2008

In Defense of Subprime

Both Sen. Obama and Sen. McCain have attacked everybody from hedge fund managers to oil companies for the doldrums that our economy is in. The root of all evil, as many would have us believe, is the subprime mortgage market and predatory lenders. Yet I believe subprime is an instrument of financial innovation that is useful.
The theory behind subprime lending is that offering mortgages to people with poor credit and erratic earnings will increase risk exposure and thus returns if mortgage payments are made. The purchasers of the mortgage have the potential to own their own home and tap the equity in their home, and ultimately both sides win. With this basic definition, subprime lending certainly seems like a rational decision to make, especially in light of the low interest rates and soaring home prices of the 1990s and early 2000s.
Subprime loans certainly have their problems, but so has nearly every other financial innovation. The University of Chicago economist Gary Becker compares subprime loans to junk bonds. When junk bonds entered the scene in the 1980s they were ridiculed as a high-risk asset that hurt investors who did not fully understand the extent of the risk they were taking on. Ultimately, however, junk bonds have allowed many companies, including start-ups, to access capital that could not otherwise be attained. This same story is playing out in the subprime market as we speak.
The dream of every American couple is to own their own home. Unfortunately, politicians who encourage homeownership are misguided and reality is such that maybe not every American should have his own home. I know it is a harsh reality, but some may be better off building up their credit and increasing their personal savings rates. As for those who entered into these subprime mortgages and defaulted, they had the option to forgo these subprime loans, yet based upon all available choices they chose to enter the subprime market. There is nothing wrong with this, nor is there anything wrong with defaulting on the mortgage. Both lender and borrower must assume the worst-case scenario will occur and understand as well as assume all risks. Some may retort that predatory lending was rampant and resulted in hundreds of uneducated minorities entering in to contracts they did not understand. I have seen no data to support this. Furthermore, mortgage delinquencies hurt both the borrower and the lender. Just talk to all those “hot-shot Wall Street types” who are now out of jobs.
The problem with the subprime mortgage market is that politicians on both sides of the aisle have encouraged homeownership for decades. The Community Reinvestment Act (CRA) of 1977 offered lending institutions incentives to issue loans to low income borrowers in impoverished, urban areas. In 1980, the Depository Institutions Deregulatory and Monetary Control Act dramatically relaxed usury laws on mortgage rates. When it comes to information, the government must be in the business of providing it or regulating it. According to the Federal Reserve, as of 2003, 45 percent of subprime loan originators were subject to government compliance exams, while the rest of the market was subject to lesser regulation. Government encouragement of subprime mortgages as well as the financial packaging and selling of these mortgages has given the subprime market a bad name. However, it is not the subprime market that deserves the blame. Since the beginning of time, man has taken on higher risk in order to seek higher returns.
There are two final notes I want to point out. The first is that those who loaned these mortgages and those who invested in them are in pain as a result of a bad investment. Those who purchased and formulated CDOs (collaterized debt obligations) and MBSs (mortgage-backed security) are not all lying atop a pile of Benjamin Franklin’s. Subprime mortgages have, however, allowed many people who never dreamed of owning a home to finally become homeowners. The actual product and idea of subprime mortgages is a rational one that can benefit all parties involved. Simply because financial innovation is not all rosy is no reason to discourage it, nor is it a reason for taxpayers to bear the burden.

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Economists are scientists. They take data. They run statistical tests. Then, they boil down human behavior to elegant mathematical models: G+I+Xn+C =GDP, MRS=-p1/p2 etc. However, as sophisticated as these models may be, they don’t always work in practice.

Several years ago, the returns of two portfolios compiled by a brie eating, Armani wearing analyst at Merrill Lynch and an innocent monkey throwing darts at a page of the Wall-Street Journal were compared, and the differences were negligible. The Subprime mortgage, created by intelligent Ivy League graduates fluent in computer programming and financial modeling, shattered the global economy and literally brought the house down. Your browser may not support display of this image.

Last week, Wall Street experienced its most severe credit crisis since the Great Depression. Several long-standing monetary institutions, including investment banks Lehman Brothers and Merrill Lynch, and American International Group, crashed, and the Dow Jones Industrial average fell over 800 points by mid-week before rebounding significantly on Thursday and Friday.